Oscillators and Momentum Indicators
We’ve covered a hell lot of tools that can help you analyze charts and identify trends. In fact, you may now have too much information to use effectively.
In this lesson, we’re going to look at streamlining your use of these chart indicators. We want you to fully understand the strengths and weaknesses of each tool, so you’ll be able to determine which ones work for you and your trading plan…and which ones don’t.
Leading versus Lagging Indicators
Let’s discuss some concepts first. There are two types of indicators: leading and lagging.
A leading indicator gives a buy signal before the new trend or reversal occurs.
A lagging indicator gives a signal after the trend has started and basically informs you “hey buddy, pay attention, the trend has started, you’re missing the boat.”
You’re probably thinking, “Boohoo, I’m going to get rich with leading indicators!” since you would be able to profit from a new trend right at the start. You’re right – you would “catch” all of the trend every single time IF the leading indicator was correct every single time. But it’s not. When you use leading indicators, you will experience a lot of fake outs. Leading indicators are notorious for giving bogus signals which will “mis-lead” you.
Get it? Leading indicators that "mis-lead" you? Ha-ha. Man I'm so funny I even crack myself up.
The other option is to use lagging indicators, which aren’t as prone to bogus signals. Lagging indicators only give signals after the price change is clearly forming a trend. The downside is that you’d be a little late in entering a position. Often the biggest gains of a trend occur in the first few bars so by using a lagging indicator you could potentially miss out on much of the profit. This sucks.
Oscillators and Trend Following Indicators
For the purpose of this lesson, let’s broadly categorize all of our technical indicators into one of two categories:
1. Oscillators
2. Trend following or momentum indicators
Oscillators are leading indicators.
Momentum indicators are lagging indicators.
While the two can be supportive of each other, they're more likely to conflict with each other. I’m not saying that one or the other should be used exclusively, but you must understand the potential pitfalls of each.
Oscillators/Leading Indicators
An oscillator is any object or data that moves back and forth between two points. In other words, it’s an item that is going to always fall somewhere between point A and point B. Think of when you hit the oscillating switch on your electric fan.
Think of our technical indicators as either being “on” or “off”. More specifically, an oscillator will usually signal “buy” or “sell”, with the only exception being instances when the oscillator is not clearly at either end of the buy/sell range.
Does this sound familiar? It should! Stochastics, Parabolic SAR, and the Relative Strength Index (RSI) are all oscillators. Each of these indicators is designed to signal a possible reversal, where the previous trend has run its course and the price is ready to change direction.
Let’s take a look at a few examples.
On this 1-hour chart of USD/EUR below, we have added a Parabolic SAR indicator, as well as an RSI and Stochastic oscillator. As you have already learned, when the Stochastic and RSI begin to leave their “oversold” region. That is a buy signal. Here we get sell signals between the hours 3:00 am EST and 7:00 am EST on 08/24/05. All three of these buy signals occurred within one or two hours of each other, and this would have been a good trade.
We also got a sell signal from all three indicators between the hours of
2:00 am EST and 5:00 am EST on 08/25/05. As you can see, Stochastic indicator remained in the overbought for a pretty long time. About 20 hours. Usually when an oscillator remains in the overbought or oversold levels for a long period of time, that means there is a strong trend occurring. In this example, since Stochastic stayed overbought, you see there was a strong uptrend present.
Now let’s take a look at the same leading oscillators messing up, just so you know these signals aren’t perfect. Looking at the chart below, you can quickly see that there were a lot of false buy signals popping up. You’ll see how one indicator says to buy, while the other one is still saying sell.
Around 1 am EST on 08/16/05, both RSI and Stochastic gave buy signals, while Parabolic SAR still showed a sell signal. Yes, Parabolic SAR gave a buy signal 3 hours later at 4 am EST, but then Parabolic SAR turned into a sell signal one bar later. If you actually look at the bar with the Parabolic SAR below it, notice how it’s a strong looking red bar with very short shadows. Also, notice how the next bar closed below it. This would not have been a good long trade.
On the last two oversold (buy) signals given by Stochastic, notice how there is no indicator at all for RSI, but Parabolic SAR is giving sell signals. What’s going on here? They are each giving you different signals!
What happened to such a good set of indicators?
The answer lies in the method of calculation for each one. Stochastic is based on the high-to-low range of the time period (in this case, it’s hourly), yet doesn’t account for changes from one hour to the next. The Relative Strength Index (RSI) uses change from one closing price to the next. And Parabolic SAR has its own unique calculations that can further cause conflict.
That’s the nature of oscillators – they assume that a particular chart pattern always results in the same reversal. Of course, that’s hogwash.
While being aware of why a leading indicator may be in error, there’s no way to avoid them. If you’re getting mixed signals, you’re better off doing nothing than taking a ‘best guess’. If a chart doesn’t meet all your criteria, don’t force the trade! Move on to the next one that does meet your criteria.
Momentum/Lagging Indicators
So how do we spot a trend? The indicators that can do so have already been identified as MACD and moving averages. These indicators will spot trends once they have been established at the expense of delayed entry. The bright side is that there’s less chance of being wrong.
On this 1-hour chart of EUR/USD, there was a bullish crossover for MACD at 3:00 am EST on 08/03/05 and the 10 period EMA crossed over the 20 period EMA at 5:00 am. These two signals were all accurate, but if you waited for both indicators to give you a bull signal, you would have missed out of the big move. If you calculate from the start of the uptrend at 10:00 pm EST on 08/02/05 to the close of the candle at 5:00 am EST on 08/03/05, you would’ve watched a gain of 159 pips while sitting on the sidelines.
Let’s take a look at the same chart so you can see how these crossover signals can sometimes give false signals. I like to call them “fakeouts”. Look at how there was a bearish MACD crossover after the uptrend we just discussed. Ten hours later, the 20 EMA crossed below the 10 EMA giving a “sell” signal. As you can see, the price didn’t drop but stayed pretty much sideways, then continued its uptrend. By the time both indicators were in agreement, you would’ve entered a short trade at the bottom and set yourself up for a loss. Bummer dude.
The Million Dollar Question
How do you figure out whether to freaking’ use oscillators, or trend following indicators, or both? After all, we know they don’t always work in tandem.
This is probably the most challenging part about technical analysis. And why I call it the million dollar question.
We will provide the million dollar answer in a future lesson.
For now, just know that once you're able to identify the type of market you are trading in, you will then know which indicators will give accurate signals, and which ones are worthless at that time.
This is no piece of cake. But it's a skill you will slowly improve upon as your experience grows.
Summary:
- There are two types of indicators: leading and lagging.
- A leading indicator gives a buy signal before the new trend or reversal occurs.
- A lagging indicator gives a signal after the trend has started
- Technical indicators into one of two categories: Oscillators and trend following or momentum indicators.
- Oscillators are leading indicators.
- Momentum indicators are lagging indicators.
- If you're able to identify the type of market you are trading in, you will then know which indicators will give accurate signals, and which ones are worthless at that time.
The only place success comes before work is in the dictionary.
By now you have an arsenal of weapons to use when you battle the market. In this lesson you will add yet another weapon: CHART PATTERNS!
Think of it as a land mine detector because once you learn it, you will be able to spot “explosions” on the charts before they even happen, and potentially make you a lot of money in the process.
In this lesson, I will teach you basic chart patterns and formations. When correctly identified, it usually leads to a huge breakout or “explosion” in this case. Remember, our whole goal is to spot big movements before they happen so that we can ride them out and rake in the cash! Chart formations will greatly help us spot conditions where the market is ready to break out.
Here's the list of patterns that we're going to cover:
- Symmetrical Triangles
- Ascending Triangles
- Descending Triangles
- Double Top
- Double Bottom
- Head and Shoulders
- Reverse Head and Shoulders
Symmetrical triangles are chart formations where the slope of the price’s highs and the slope of the price’s lows converge together to a point where it looks like a triangle. What is happening during this formation is that the market is making lower highs and higher lows. This means that neither the buyers nor the sellers are pushing the price far enough to make a clear trend. If this was a battle between the buyers and sellers, then this would be a draw. This type of activity is called consolidation.
In the chart above, we can see that neither the buyers nor the sellers could push the price in their direction. When this happens we get lower highs and higher lows. As these two slopes get closer to each other, it means that a breakout is getting near. We don’t know what direction the breakout will be, but we do know that the market will break out. Eventually, one side of the market will give in. So how can we take advantage of this? Simple. We can place entry orders above the slope of the lower highs and below the slope of the higher lows. Since we already know that the price is going to break out, we can just hitch a ride in whatever direction the market moves.
In this example, if we placed an entry order above the slope of the lower highs, we would’ve been taken along for a nice ride up. If you had placed another entry order below the slope of the higher lows, then you would cancel it as soon as the first order was hit.
This type of formation occurs when there is a resistance level and a slope of higher lows. What happens during this time is that there is a certain level that the buyers cannot seem to exceed. However, they are gradually starting to push the price up as evident by the higher lows.
In the chart above, you can see that the buyers are starting to gain strength because they are making higher lows. They keep putting pressure on that resistance level and as a result, a breakout is bound to happen. Now the question is, “Which direction will it go?” “Will the buyers be able to break that level or will the resistance be too strong?”
Many charting books will tell you that in most cases, the buyers will win this battle and the price will break out past the resistance. However, it has been my experience that this is not always the case. Sometimes the resistance level is too strong and there is simply not enough buying power to push it through.
Most of the time the price will in fact go up. The point I am trying to make is that we do not care which direction the price goes, but we want to be ready for a movement in EITHER direction. In this case, we would set an entry order above the resistance line and below the slope of the higher lows.
In this scenario, the buyers won the battle and the price proceeded to skyrocket!
As you probably guessed, descending triangles are the exact opposite of ascending triangles (I knew you were smart!). In descending triangles, there is a string of lower highs which forms the upper line. The lower line is a support level in which the price cannot seem to break.
In the chart above, you can see that the price is gradually making lower highs which tell us that the sellers are starting to gain some ground against the buyers. Now most of the time, and I did say MOST; the price will eventually break the support line and continue to fall. However, in some cases, the support line is too strong, and the price will bounce off of it and make a strong move up.
The good news is that we don’t care where the price goes. We just know that it’s about to go somewhere. In this case we would place entry orders above the upper line (the lower highs) and below the support line.
In this case, the price did end up breaking the support line and proceeded to drop rather quickly. (*note- The market tends to fall faster than it rises which means you usually make money faster when you are short).
A double top is a reversal pattern that is formed after there is an extended move up. The “tops” are peaks which are formed when the price hits a certain level that can’t be broken. After hitting this level, the price will bounce off of it slightly, but then return back to test the level again. If the price bounces off of that level again, then you have a DOUBLE top!
In the chart above you can see that two peaks or “tops” were formed after a strong move up. Notice how the 2nd top was not able to break the high of the 1st top. This is a strong sign that a reversal is going to occur because it is telling us that the buying pressure is just about finished.
With double tops, we would place our entry order below the neckline because we are anticipating a reversal of the uptrend.
Wow! I must be a psychic or something because I always seem to be right! Looking at the chart you can see that the price breaks the neckline and makes a nice move down. Remember, double tops are a trend reversal formation. You’ll want to look for these after there is a strong uptrend.
Double bottoms are also trend reversal formations, but this time we are looking to go long instead of short. These formations occur after extended downtrends when two valleys or “bottoms” have been formed.
You can see from the chart above that after the previous downtrend, the price formed two valleys because it wasn’t able to go below a certain level. Notice how the 2nd bottom wasn’t able to significantly break the 1st bottom. This is a sign that the selling pressure is about finished, and that a reversal is about to occur. In this situation, we would place an entry order above the neckline.
Would you look at that! The price breaks the neckline and makes a nice move up. Remember, just like double tops, double bottoms are also trend reversal formations. You’ll want to look for these after a strong downtrend.
Head and Shoulders
A head and shoulders pattern is also a trend reversal formation. It is formed by a peak (shoulder), followed by a higher peak (head), and then another lower peak (shoulder). A “neckline” is drawn by connecting the lowest points of the two troughs. The slope of this line can either be up or down. In my experience, when the slope is down, it produces a more reliable signal.
In this example, we can visibly see the head and shoulders pattern. The head is the 2nd peak and is the highest point in the pattern. The two shoulders also form peaks but do not exceed the high of the head.
With this formation, we look to make an entry order below the neckline. We can also calculate a target by measuring the high point of the head to the neckline. This distance is approximately how far the price will move after it breaks the neckline.
You can see that once the price goes below the neckline it makes a move that is about the size of the distance between the head and the neckline.
The name speaks for itself. It is basically a head and shoulders formation, except this time it’s in reverse. A valley is formed (shoulder), followed by an even lower valley (head), and then another higher valley (shoulder). These formations occur after extended downward movements.
Here you can see that this is just like a head and shoulders pattern, but it’s flipped upside down. With this formation, we would place an long entry order above the neckline. Our target is calculated just like the head and shoulders pattern. Measure the distance between the head and the neckline and that is approximately the distance that the price will move after it breaks the neckline.
You can see that the price moved up nicely after it broke the neckline. I know you’re thinking to yourself, “the price kept moving even after it reached the target.” And my response is, “DON”T BE GREEDY!” If your target is hit, then be happy with your profits. However, there are strategies where you can lock in some of your profits and still keep your trade open in case the price continues to move your way. You will learn about those later on in the course.
Summary:
Chart formations are like bazookas because they often create huge explosions on the chart.
Symmetrical triangles
- Consists of lower highs and higher lows
- Place entry orders above the lower highs and below the higher lows
Ascending triangles
- Consists of higher lows and a resistance line
- It usually means that the price will break the resistance line and go higher but you should place entry orders on both sides just in case the resistance line is too strong.
- Place your entry orders above the resistance line and below the higher lows.
Descending triangles
- Consists of lower highs and a support line
- I usually means that the price will break the support line and go lower but you should place entry orders on both sides just in case the support line is too strong.
- Place your entry orders above the lower highs and below the support line.
Trend Reversal formations
Double Top
- Happens after an extended uptrend.
- Formed by 2 peaks that can’t break a certain level. This level becomes a resistance line.
- Place our short entry order below the low point of the valley in between the 2 peaks.
Double Bottom
- Happens after an extended downtrend.
- Formed by 2 valleys that can’t break a certain level. This level becomes a support line.
- Place our long entry order above the high point of the peak in between the 2 valleys.
Head and Shoulders
- Happens after an extended uptrend.
- Formed by a peak, followed by a higher peak, and then another lower peak. A neckline is formed by connecting the low points of the two troughs or “valleys”.
- Place your short entry order below the neckline.
- We calculate our target by measuring the distance between the high point of the head and the neckline. This is the approximate distance that the price will move after it breaks the neckline.
Reverse Head and Shoulders
- Happens after an extended downtrend.
- Formed by a valley, followed by a lower valley, and then another higher valley. A neckline is formed by connecting the high points of the 2 peaks.
- Place your long entry order above the neckline.
- We calculate our target by measuring the distance between the low point of the head and the neckline. This is the approximate distance that the price will move after it breaks the neckline.
We are what we repeatedly do. Excellence, then, is not an act, but a habit.
- Aristotle
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